Ch 16.1 (Dilutive Securities) Flashcards
Dodd-Frank Act
Results in SEC rules requiring companies to disclose:
> The median of the annual total compensation of all employees of the company, except the CEO.
> The annual total compensation of its CEO.
> The ratio of the two amounts.
Dilutive Securities
Upon exercise, convertible securities as well as options, warrants, and other securities may reduce (dilute) earnings per share.
Securities that have characteristics of both debt and equity.
Convertible Bonds
Can be changed into other corporate securities during some specified period of time after issuance.
A convertible bond combines the benefits of a bond with the privilege of exchanging it for stock at the holder’s option.
Accounting for convertible debt involves reporting issues at the time of (1) issuance, (2) conversion, and (3) retirement.
Why do corporations issue convertible securities?
Corporations issue convertible securities for two main reasons.
> One is to raise equity capital without giving up more ownership control than necessary.
> A second reason to issue convertibles is to obtain debt financing at cheaper rates.
How to record convertible bonds at the date of issue?
Recording convertible bonds at the date of issue follows the method used to record straight debt issues.
IFRS requires that the issuer of convertible debt record the liability and equity components separately.
Recording the conversion of bonds into other securities
If converting bonds into other securities, a company uses the book value method to record the conversion.
The book value method records the securities exchanged for the bond at the carrying amount (book value) of the bond.
Support for the book value approach is based on the argument that an agreement was established at the date of the issuance either to pay a stated amount of cash at maturity or to issue a stated number of shares of equity securities.
Induce Conversion
Issuer wishes to encourage prompt conversion of its convertible debt to equity securities in order to reduce interest costs or to improve its debt to equity ratio. Thus, the issuer may offer some form of additional consideration (such as cash or common stock).
The issuing company reports the sweetener as an expense of the current period. Its amount is the fair value of the additional securities or other consideration given.
FASB indicated that when an issuer makes an additional payment to encourage conversion, the payment is for a service (bondholders converting at a given time) and should be reported as an expense.
Recording retirement of convertible debt
Companies need to recognize a gain or loss on retiring convertible debt in the same way that they recognize a gain or loss on retiring nonconvertible debt. For this reason, companies should report differences between the cash acquisition price of debt and its carrying amount in current income as a gain or loss.
Convertible Preferred Stock
Includes an option for the holder to convert preferred shares into a fixed number of common shares.
In accounting for the exercise of convertible preferred stock, a company uses the book value method. It debits Preferred Stock, along with any related Paid-in Capital in Excess of Par—Preferred Stock, and it credits Common Stock and Paid-in Capital in Excess of Par—Common Stock (if an excess exists).
The treatment differs when the par value of the common stock issued exceeds the book value of the preferred stock. In that case, the company usually debits Retained Earnings for the difference. Many states, however, require that this charge simply reduce additional paid-in capital from other sources.
